Deloitte dodges a bullet

Last Wednesday a federal judge dismissed Deloitte from the class action lawsuit that had been filed on behalf of shareholders of Longtop Financial Technologies (Longtop). Longtop collapsed in 2011 under allegations of fraud. Deloitte resigned as Longtop’s auditors after finding out that the bank confirmation process had been corrupted. Deloitte had been the reporting accountants for Longtop for six years.

While Longtop and its Chinese executives were also included in the class action lawsuit, they have yet to make an appearance, leaving only former CFO Derek Palaschuk to answer the suit. Deloitte was the best chance for shareholders to make any recovery.

The judge issued a 40 page opinion explaining his decision to let Deloitte off the hook. The case against Deloitte alleged a violation of Section 20(a) of the Exchange Act. I am no lawyer, yet my reading of the statute and the judge’s opinion is that Deloitte had to be found to have knowingly or recklessly aided in the fraud to be held liable under this rule. This follows the Private Securities Litigation Reform Act of 1995 (PSLRA) that requires proof that the defendant acted with a particular state of mind. PSLRA has made it very difficult for investors to sue auditors. Under the PSLRA standard, Deloitte had to either have participated in the fraud or acted so recklessly that they allowed it to happen.

The complaint argued that Deloitte was reckless and violated generally accepted auditing standards. It argues that Deloitte ignored obvious red flags and falsely stated that its audits were conducted in accordance with PCAOB standards. The fact that short sellers discovered the frauds was cited as evidence that Deloitte did not employ the required level of professional skepticism. Comments by Longtop CFO Derek Palaschuk raise questions about whether Deloitte met the critical independence standard: “For me,” Palaschuk said, “the most important relations I have other than with my family, my C.E.O., and then the next on the list is Deloitte as our auditor, because their trust and support is extremely important.”

The judge disagreed. “DTTC’s failure – along with the SEC and the market – to suspect Longtop on the basis of its high gross margins is too thin a reed on which to hang a finding of recklessness…the complaint does little more than allege that, had DTTC performed a better audit, Longtop’s fraud would have been uncovered sooner. Considering the allegations in the Complaint as a whole, the strongest inference is that DTTC was duped by Longtop, not that it recklessly enabled them.”

The judge gave the plaintiffs a month to replead their case, but warned them “there is cause for suspicion that amendment here would be futile”.

That might be the law, but it is incredibly frustrating to investors. Deloitte is currently in federal court arguing about whether it must turn over the Longtop working papers to the SEC. China has objected, threatening to jail the Deloitte partners if they do so. The SEC asked for a six-month stay in this case while it tried to work out arrangements with Chinese authorities. They are due back in Court in January. The working papers would tell if Deloitte were reckless in its audit.

While Deloitte claims to have conducted the Longtop audit following PCAOB standards, we have no way to know whether that is true. Chinese regulators have banned the PCAOB from coming to China to inspect Deloitte and other registered firms to determine whether they are doing their work following PCAOB standards.

It looks like shareholders are unlikely to see justice in these cases. Private Chinese companies that list abroad do so through offshore holding companies, typically organized in the Cayman Islands. They do that to get out from under Chinese regulation, so the Chinese Securities Regulatory Commission is unable to regulate the companies. As far as I know, Chinese regulators have done nothing to bring the perpetrators of the Longtop fraud to justice. U.S. regulators – the PCAOB and the SEC – can’t regulate these companies either. That is because the people and records are in China and Chinese authorities will not allow U.S. regulators to operate on Chinese soil. Consequentially, these companies have fallen into a regulatory hole where neither Chinese nor U.S. regulators can hold them accountable. No wonder we have seen so much fraud.